IS BG DEAL A GOOD IDEA FOR SHELL?

By: Garry White

Mergers don’t come much bigger than this. A combination of BG and Shell would be the largest corporate transaction in the oil sector since the oil price collapse and the biggest energy sector deal for 17 years. The only energy sector merger that was larger than this mooted combination was the $75bn merger of Exxon and Mobil in 1998.

Shell shares have been weak since the talks were revealed. One reason for this is concerns about what the deal will do to its balance sheet. Debt is going to rise and some fear that this could, ultimately, result in a one-notch downgrade to its credit rating – a move which will increase the cost of its borrowings.

Gearing, which is a measure of a company’s indebtedness, will rise from around 20% to about 30%. However, management have agreed to sell a significant amount of disposals once the deal completes. Indeed, Shell chief executive Ben van Beurden has identified at least $30bn of assets to put up for auction from the combined group.

Another concern relates to dilution of existing shareholders. About 1.5bn new “B” shares will be issued to fund the deal, giving BG shareholders a 19pc stake in the new combined company. Also, with the deal being pitched at a premium of about 50% to BG’s share price before the talks became public, there are fears that the company could be overpaying. The price appears to be pitched at a high enough level to make any counter-bidders think twice.

Despite these worries, strategically, the deal appears to make sense. BG has some very attractive assets, including its deep-water operations in Brazil and its liquefied natural gas (LNG) portfolio. It has been estimated that a merged company would control about 16% of the global market. It shores up Shell’s strong position in the sector and makes it a leading player in Pacific Rim energy markets.

There has also been much comment that this will boost Shell’s oil reserves – a factor that some had been concerned about. Last year the company’s reserve replacement ratio was just 26%. This figure measures the amount of proved oil reserves Shell added to its books relative to the amount of oil and gas it extracted. In order to properly “grow”, an oil company needs to book more reserves than it takes out of the ground and have a reserve replacement ratio of more than 100%.

However, reserves are only booked when an investment decision is made and Shell had one of its best years ever in 2014 in terms of new discoveries, so fears about reserve replacement are possibly overcooked. Nevertheless, the combined entity will see Shell’s reserve rise by about 25% and production will increase 20%. This is positive.

Shell’s management also said the group would pay a dividend of $1.88 per share in 2015 and at least the same amount in 2016. It also expects to start a share buyback programme in 2017 of at least $25bn for the period 2017 to 2020.

So, for owners of Shell shares, the dividend appears secure. As the shares are mainly held for income, this is reassuring news and the prospective yield in the current year is a chunky 5.8%. There are about $2.5bn of cost savings to be extracted the merger and the assets complement Shell’s existing businesses.

The deal promises much, but there is always risk in the execution. However, from a strategic point of view, the deal looks good for both Shell and BG.

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Charles Stanley & Co